Regulation's Fatal Flaw

Bureaucrats who try to peg prices to production costs face an impossible task—because these costs include factors known only to the businessman.


The natural gas shortages during the past two winters vividly illustrate the effects of government regulation. Although natural gas and other energy shortages can be traced directly to government intervention, this fact is still not generally accepted by most politicians, newspaper editors, television commentators, or, indeed, by the public at large. Instead, numerous other specious reasons are cited for energy shortages. How often have you heard them attributed to the lack of "a national energy policy" or to the failure of citizens to practice proper "conservation" measures?

Although there is no consensus as to the cause of our energy problems, there is widespread dissatisfaction with regulatory activities at both state and federal levels. Increasingly, questions are being raised about their effectiveness, and we find such disparate observers as Milton Friedman and Ralph Nader being highly critical of the results of government regulation of economic activity. Yet, there is a profound difference of opinion as to why government regulation is failing to achieve its stated purpose. Friedman contends that its shortcomings are innate in the political process. Nader, on the other hand, places the blame on the leadership of the regulatory agencies: the solution lies in stronger regulatory agencies with "better" regulators. Could it be that neither of these explanations is adequate?

Though all government regulation is beset with problems, price regulation is an interesting case of its own. The ostensible aim of government intervention in the price field is to ensure that price is based on production costs. Despite the opinion from diverse circles that economic regulation is not achieving its stated purpose, there is increasing pressure to have the prices of electricity, oil, natural gas, and even agricultural products pegged to production costs. President Carter assured farmers during his presidential campaign that farm prices should be high enough to cover production costs. A major feature of his 1977 farm bill was the linking of price supports for agricultural products to production costs.

All of this assumes that the costs relevant to production decisions can, in fact, be determined by government regulators. Politicians have assumed this blithely, but even most economists have paid relatively little attention to problems faced by outside observers in determining costs as they influence production. In fact, however, it is impossible for the outside observer to measure costs that motivate individual choices. Hence government regulation cannot achieve its objectives. The basic problem lies not in laxity, ineptitude, or venality on the part of leadership and staff of the regulatory commissions. The difficulty is that costs are inherently subjective, so regulators can't set prices or rates of return on the basis of production costs. This inability to measure cost objectively is largely unrecognized even by economists, except for members of the Austrian school—Ludwig von Mises, Murray Rothbard, et al.


All economists define cost in terms of opportunity cost. The opportunity cost of any decision involves the decisionmaker's conscious sacrifice of an available opportunity. The cost of a vacation trip, for example, is the value of the boat or refrigerator (and other alternatives) forgone if the trip is taken. Since cost as it influences the decisionmaker's choice is based on his unique anticipations, it cannot be discovered by another person. This is the insight of the Austrian economists—that the cost of any activity is inherently subjective. There is no way for outside observers to objectively measure the costs relevant to decisions actually made.

The generally accepted economic definition of cost in terms of opportunities forgone is consistent only with the basic subjectivist approach of the Austrians. Yet conventional, non-Austrian economists assume that cost is objective, that the cost of production incurred by a particular firm in producing wheat, electricity, and other products can be determined by outside observers. So to Mr. Jones, for example, the "cost" of operating his automobile can be obtained by merely adding together the outlays for gasoline, oil, tires, and other variable expenses required per mile of travel.

Summing up outlays actually incurred, however, does not provide the relevant cost that motivates individual behavior. Outlays actually incurred by an individual or business firm are historical "costs." Although the IRS requires that historical costs be used for tax purposes, they are not relevant to current choices. Historical costs all fly in the face of a basic economic principle—"bygones are forever bygones," or "past costs are lost costs." The relevant costs in any economic decision are whatever costs vary with the decision to be made—the opportunity costs. Accounting "cost" data, on the other hand, are always historical and therefore cannot reveal the opportunity costs that motivate choice. Since opportunity costs are based on expectations and are necessarily subjective, decisionmaking activity requires more than a capacity for arithmetical calculations. It also requires subjective judgment by the decisionmaker.


Why can cost not be determined independently of subjective judgments? Consider Mr. Jones and the cost of operating his automobile. There are many possible ways in which subjectivity enters cost calculations. For example, estimated overhead expenses, including depreciation and interest, cannot be computed independently of the expected life of the car. The expected life of an auto, however, is uncertain and subjective, varying with the decisionmaker's views about future use and obsolescence. There is no way for Consumer's Union or any other outside observer to determine the overhead costs relevant to any particular decision made or contemplated by Mr. Jones about purchasing or replacing his auto. There is no consensus on the cost of operating a given size and make of auto because subjective judgments are inherent in cost.

The same basic problem is faced, regardless of the type of economic activity, in determining the overhead cost of capital plant and equipment. Any planning activity must deal with an uncertain future. Expectations concerning future demand and cost conditions are always crucial in determining whether to continue to operate with present facilities or to replace plant or equipment. Again, the "cost" records of a business firm may bear little relationship to the opportunity costs that motivate the decisionmaker. Yet the regulator as an outside observer has access only to these historical cost data.

For Mr. Jones, subjectivity also enters cost estimates when placing a value on his time. What is the appropriate cost of time to use in estimating his cost of operating an automobile? It is the opportunity cost of the time spent in driving. In going on a particular trip, Jones may prefer to travel by plane rather than auto because he places a high value on the time required to drive. Traveling by car is a very expensive way to travel for individuals for whom the opportunity cost of time is high. Only Mr. Jones, however, can accurately value the alternatives forgone from time spent in driving.

We observe that middle-income people are more likely to travel by car and high-income people are more likely to travel by air. In some cases, however, this will be reversed—which doesn't mean that the opportunity cost of time isn't important. It reflects the fact that the opportunity cost of time varies widely among persons and for a given person depending upon the particular circumstances.

A moment's reflection is all that is required to see that the opportunities forgone by Mr. Jones when he chooses to drive instead of fly are subjective and impossible for an outside observer to measure. The key point is that the decisionmaker alone is able to evaluate the value of the alternatives forgone as a result of the action taken. This explains why objective cost estimates are often inconsistent with observed behavior. People drive their cars when objective "cost" estimates show that it would be less expensive to go by bus or to car pool. The problem with these and other similar examples is that the objective estimates of "cost" do not correspond to the subjective costs that motivate individual behavior.

How is the Austrian approach to cost related to the conventional approach? In conventional neoclassical economic theory, it is assumed that costs and returns are given or known to economic actors and observers. Abba Lerner, for example, in a recent paper discusses the advantages and disadvantages in public utility regulation of setting price on the basis of "marginal costs" versus "average costs." It is implicit throughout the paper that data on costs and demand are given (or that there is no problem in obtaining these data) and that the only problem is to decide the appropriate pricing policy. The Austrian approach, on the other hand, stresses the fact that data on costs are not given, that a key function of any decisionmaker is to estimate prospective costs in choosing, and that these costs are necessarily subjective.


The distinction between objective and subjective views of cost has definite implications for the theory of economic regulation. Most of the attention in price-setting regulation has been devoted to the problem of monitoring firm costs in the case of so-called natural monopolies. Natural monopolies are usually defined as cases in which one firm is the exclusive producer because of economies of scale in producing the good or service. Prime examples are the provision of electricity, telephone, transportation, and natural gas; and regulatory commissions are active throughout the United States, estimating production costs in order to set rates. This activity presumes that the government regulator can objectively estimate cost.

Regulatory commissions were set up to insure that public utilities and other "natural monopolies" charge a competitive price (or rate of return) as determined by production costs. Here, they can rely only on the firms' accounting "cost" records, which reflect historical costs and not the opportunity costs that motivate entrepreneurial behavior. Attempts to force utilities to set price equal to opportunity cost can be no more than hollow appeals.

Since the costs that motivate the decisionmaker cannot be determined by outside observers, it is not surprising that economic studies find the effects of regulatory commissions to be quite different from those envisaged by the original proponents of regulation. Stigler and Friedland, for example, in a pioneering study, found the regulation of electrical utilities to have no significant effect on utility rates.

It may well be that regulation that has no effect on rates is most fortunate from the consumer's standpoint. There is no reason to expect that holding down current rates and thereby curtailing future supply below the level of an unregulated public utility will redound to the benefit of the public. It is much more likely that the effects will be similar to those of price controls on oil and natural gas. Energy shortages of natural gas during recent winters can be directly attributed to these controls, which reduced production and increased desired consumption relative to the production and consumption levels dictated by market conditions.

Cost of production as it influences producer decisions will vary from producer to producer depending upon the entrepreneur's assessment of present and future production conditions. The value of foregone alternatives (opportunity cost) will vary from producer to producer both because the alternatives vary and because decisionmakers assess the alternatives differently. Forays by regulators into firm records containing historical data can provide little or no useful information from the public policy standpoint.


Price regulation has not been confined to "natural monopolies" where, due to economies of scale in production, it is often alleged that there are not enough firms to have effective competition. Economic regulation of agricultural prices has also been widespread even though agricultural markets in the United States are highly competitive.

When product price is not set at the competitive level, the regulator faces the problem of determining what the price should be—the same problem as that faced by Aristotle and others who sought the "just price." In the case of agricultural price supports, where price is deliberately set above the competitive level, the regulator has no objective basis for setting price even if there were no problems in determining production costs. In reality, of course, the problem of determining farm production costs is subject to the same barrier discussed above—there is no way for an outside observer to determine or measure those costs that motivate entrepreneurial behavior.

What are the implications of Carter's farm bill, which bases agricultural price supports on production costs? The cases of milk, tobacco, peanuts, and other agricultural products where price is deliberately set above the competitive price level illustrates another important point related to cost. When the price of any product is set above the competitive price level, the increase in product price will be capitalized into input prices through competitive market forces so that production outlays or costs will rise to meet returns. In the Austrian terminology, it is peanut prices that determine peanut production costs and not production costs that determine peanut prices.

Peanut prices are increased in the United States through a government-operated cartel that restricts the quantity of peanuts produced. This is effected by means of acreage allotments assigned to individual farmers. Under such an arrangement, the allotment, or right to produce, acquires a value. A recent study, for example, estimated that the annual value of peanut allotments in President Carter's home state of Georgia was about $150 per acre per year in 1973. This means that a farmer producing peanuts incurs a cost of $150 per acre for the right to produce peanuts. That it is a cost is clear if we consider that one of the farmer's available alternatives is to sell his farm, and the selling price would reflect the value of anticipated future returns from peanut farming and the value of the allotment, or the privilege of earning those returns. An increase in the price-support level for peanuts will increase the value of peanut allotments and thus increase the "cost" of production. The use of expenditure data obtained from records of peanut producers can provide no useful guidance in setting price, since a price-support program effective in increasing producer prices will also increase costs.

The implication is that once the price for any product is set above the competitive level, production must be restricted in order to maintain that price, and the right to produce will acquire a value. Competition will cause the price of the right to produce—whether it be peanut allotment or taxi medallion—and other inputs to rise sufficiently so that the producer receives no pure profit. That is, prices of production inputs (including the right to produce) and other inputs will be bid up so that expected production outlays just equal expected returns. Thus, the best estimate of the cost of producing any product under these conditions is given by the market price!

This example of the effect of the peanut price-support program shows why government programs designed to help a particular group frequently do not succeed in doing so. The peanut program, for example, generated windfall gains (in the form of peanut acreage allotments) for individuals producing peanuts at the time the program was instituted. After the program was begun, however, the gains were incorporated by competitive forces as increased production costs, and producers entering production later earned only a normal return on investment. The same phenomenon is observed in the case of taxi medallions and similar grants of monopoly privilege by the state. This has led to (David) Friedman's Second Law—"the government can't even give anything away."


While there is widespread dissatisfaction with economic regulation, there is no consensus among consumer interests or economists concerning the poor performance of regulatory commissions. Ralph Nader, Milton Friedman, George Stigler, and others have contended that government regulation to protect consumers in the case of the ICC, FTC, CAB, etc., is ineffective because regulatory agencies are "captured" by the interests being regulated. That is, the regulatory agencies are used, to protect monopoly positions, by the very industries they are supposed to regulate.

What is the solution? For Ralph Nader, it is simple—stronger regulatory bodies with better people in charge. Friedman and Stigler, on the other hand, hold that the poor performance of regulation is innate in and destined by the political process itself. As Friedman states, "What reformers so often fail to recognize is that social, political, and economic pressures determine the behavior of the men supposedly in charge of a governmental agency to a far greater extent than they determine its behavior. No doubt there are exceptions, but they are exceedingly rare—about as rare as barking cats."

Professor Coase attributes the poor performance of the regulatory commissions not only to "government failure," as suggested by Friedman and Stigler, but also to "economists' failure"—referring to the inability of analysts to solve the economic problems involved in the regulation of economic activity. He, however, is hopeful that this latter failure can be overcome. With respect to price regulation, at least, that is a dream. There is a fundamental reason for the poor performance of government regulation as it affects prices in regulated industries; regulators can't regulate, because they are unable to obtain the relevant data.

Conventional economists, though aware of difficulties in estimating cost, have not attributed the difficulties to the proper source. In conventional economic theory, the price system is viewed largely as a means of transmitting already known information. Emphasis is placed upon maximization of satisfaction or profits given the conditions relating to cost (and returns). The Austrians, on the other hand, emphasize the market as an information system and stress the subjective nature of economic data and the consequent impossibility of objectively measuring the data that motivate individual choice.

The issues involved in economic regulation are closely related to the Lange-Hayek (Mises) debate of the 1920s and 1930s concerning rational economic calculation in a socialist economy. Lange contended (as do many prominent economists today) that resources can be efficiently allocated by letting the planners simulate competitive markets. The approach of "market socialism" or "planning without markets" is: "The state planning agency, given knowledge of individual preference patterns and production functions, could use a high speed computer to solve the constrained maximization problem. The resulting Lagrange multipliers are 'shadow prices' which are the equivalent of market determined prices." As Hayek stressed, however, this approach assumes away information problems. In assuming that knowledge is available to the decisionmaker, "it systematically leaves out what is our main task to explain."

The "state of the debate" has not appreciably changed since Hayek's assessment in 1935. Theorists of central planning have not solved the information problems endemic in any socialist system. The conventional economic approach to economic regulation also largely ignores information problems. It assumes that data on cost (and returns) are already known and concentrates on the relative merits of various pricing policies.

An appreciation of the subjective nature of cost shows why economic regulation must inevitably fall short of expectations. The political problems concerned with regulation are formidable, as Friedman, Stigler, and other members of the Chicago School have stressed. Aside from these problems, however, price could not be set on the basis of cost—because the relevant data cannot be obtained—even if Ralph Nader or Friedman's "barking cat" were in charge of a regulatory agency.

E.C. Pasour, Jr., teaches in the economics and business department at North Carolina State University at Raleigh. He has written for various journals as well as for magazines, including REASON.